by Connie Madon
Nov 5th 2009 (bloggingstocks) — The US dollar is down 20% since 2002 on a trade weighted basis. Other world economies like China are dynamic, with growth rates of 8 and 9%. With that kind of clout, countries like China, India and Brazil, can choose where to place their reserves.

Barclays Capital Research reported that central banks placed 63% of new cash in non US currencies between April and July.

The International Monetary Fund data shows that the dollar’s share of known world reserves fell to 62.8% in the second quarter, down from 72% in 1999.

…Now to gold. India just bout 200 tons of gold from the IMF. Taiwan, the fourth largest reserve holder wants to buy more gold. China said it had increased gold holdings by 75% since 2003.

Even in light of all of this shifting by central banks into other currencies, the dollar still comprises 2/3 of global reserves and attempts to shift away from the dollar would destroy the value of central banks’ portfolios.

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Comment: Although I should be well used to it by now, it still amazes me every time I see comments like the final remark here regarding any significant shift from dollars will lead to the destruction of central banks’ portfolios. It’s almost as if the commentator is trying to help indoctrinate a paralyzing fear as a means to prevent any such attempt on the part of the CBs, and to also create enough grass-roots doubt against such an attempt ever being made that we the people won’t perceive any benefit in trying to front-run with our own flight out of dollars and into gold.

Sure, on the surface the claim seems to have merit. That is, since the central banks hold such a disproportionately large percentage of dollars among reserve assets, and given the fact that the dollars have been largely propped up in value due to this arrangement, any attempt to trim the dollar’s position would erode an important foundation of its present value and would indeed consequently undermine the value of that disproportionately large dollar-based fraction of central banks’ reserve holdings.

It is an error in thought or judgement, however, to believe that a “destruction” of the dollar portion of the portfolio would therefore proportionately destroy the portfolio as a whole. That would only be the case if all other things remained unchanged, but life seldom works out so neatly as that. Sometimes an action can set forth an immediate chain reaction that literally changes EVERYTHING you thought you knew about the situation!

For this thought exercise, a simple analogy will be helpful.

To begin, image a central bank’s vault that contained the total mixture all the present components of its reserve assets — U.S. dollars, other foreign currency, U.S. bonds, other bonds, gold, SDRs, and some other odds and ends. And to help the central bank know the day-to-day value of the reserves in that vault, image there is a computer screen mounted on the vault door that displays the total portfolio value (the sum of the floating mark-to-market values of each of the various components) being held inside. And to help you picture this base on international averages, imagine that this is an average vault in which the U.S. dollar and U.S. bonds represent 67% of the total current value whereas gold provides just 10% of the total. Under the “old normal” circumstances, the international prices of everything inside fluctuate mildly relative to each other, but for the most part the total value (ideally measured in terms of the domestic currency unit) holds modestly steady within a comfortable range.

To help envision the sort of thing that could happen under the “new normal” circumstances, picture the vault as a box that, instead of being packed with a mixture of dollars and gold and other foreign assets, is tightly packed rather with a mixture of charcoal, sulfur and potassium nitrate. (That’s right… gunpowder.) And instead of a computer screen displaying mark-to-market prices of the components, in this analogy we shall evaluate the value of the total “portfolio” by measuring it through the passage of time — marking it to market price in terms of the “domestic currency” of heat, or pressure, or volume.

In the largely unilateral world of the “old normal”, nobody would even think of burning dollars because dollars were more or less what everyone thought they wanted or needed. More was better!

But in the globalized world of the “new normal”, dollars are really just one among many similar currencies — appropriately seen as a sometimes useful but always temporary means to another desired end.

In the world of the “new normal,” it is indeed possible (and someday soon desirable) to let the fuse be lit and allow the CB store of dollars be consumed. And to be sure, it is singularly the latent potential energy of the gold component that allows us to make this analogy with gunpowder. The natural chain reaction in the tiny open market for physical gold would immediately bring to bear massive “heat” and “pressure” upon its price… **POW** thus swelling the “volume” of its value relative to all other things. So even without radical changes to the quantity of physical holdings, a simple expansion in golden value will more than compensate the average portfolio of the central banks against the destruction of the dollar component.

Still can’t wrap your head around it? Bear in mind that the gold price is not a simple one-to-one inverse relationship with the dollar. There is a great leverage lurking in there, but it has been largely masked by the artificial abundance of paper gold which weighs down upon the equilibrium price. And even so, since 2002 the dollar value has decline by just 20% on a trade-weighted basis, whereas the gold price has responded with a 300% gain. And the moreso that the public and private parties of the world rightly gravitate toward physical gold instead of the illusion of paper derivative gold as the solid foundation of their savings and diversifications, the moreso you will see this price leverage grow in favor of larger multiples of gold price gains against modest dollar losses.

Bottom line: In this interim period between the “old normal” and the “new normal”, the central banks of the world are repositioning their portfolios for an adequate admixture of explosive mark-to-market gold to offset the eventuality of dollar-value-destruction (largely brought by the hands of the private capital markets) which the CBs will quietly bear and suffer upon their huge unsalable piles of U.S. dollars and U.S. bonds (unsold in the interest of not adding more fuel to the fire!)

Again, on average the central banks have 10% gold. The ones who have less are scrambling. How about you? Do you have enough gold to put a suitable *BANG!* in your portfolio?

R.